As Europe prepares to introduce rules that will drive up the cost of over-the-counter derivatives trading, fears are growing that some investors could be left in the cold.

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The problem is that the regulations, likely to come into force next year, are making OTC derivatives business less profitable, leading investment banks to focus on their largest clients or walk away from the business altogether. This could leave smaller buyside clients out in the cold or force them to trade products that may not be suited to their needs. However, it also opens opportunities for non-traditional players to fill the void.

Christian Lee, head of the clearing, risk and regulatory practice at consultancy Catalyst, said: “The new OTC derivatives regulations may have perverse and unintended consequences. The stark reality is that some banks are not seeing OTC derivatives clearing as a service they can make money out of. This then reduces or eliminates choices for end users. By being driven out of the OTC market, end clients could actually be assuming more risk, which is the opposite of regulators’ intentions.”

Gavin Dixon, European head of derivatives clearing services at BNP Paribas, said: “There is a risk that some clients will be left in the cold as happened in the US last year. Many brokers will not necessarily have the time or resources to service all the clients that are out there. You have to prioritise and clearly, given a fixed timeline, the top priorities are going to be the clients that you already have relationships with.”

The saga began in 2009, when G20 governments mandated sweeping reforms to OTC derivatives, which at present are traded privately between counterparties, to reduce risk and increase transparency. The derivatives in question are usually products to hedge risks, such as interest rate or currency movements.

One of the measures is that these previously private deals will need to be routed via clearing houses, which will guarantee the trade even if one party collapses, reducing the risk of domino-like failures across the market. To make this guarantee possible, the clearing house holds collateral – usually cash or government bonds – which it can sell to cover the costs of any default.

In Europe, the approval of Nasdaq OMX’s clearing house in mid-March started the clock ticking for many of the most popular OTC derivatives that will need to be processed through clearing houses under rules known as the European Market Infrastructure Regulation.

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But imposing extra safeguards and new transparency requirements on a previously opaque market does not come cheap.

Safeguards

Clearing house members – i.e. brokers – must post collateral on behalf of their clients but also need to contribute to a default fund that is used by the clearing house in exceptional circumstances to cover any losses. The more clients a broker takes on, the larger the contribution it needs to make to the default fund.

As such, brokers now have an incentive to be picky about their clients.

Lee McCormack, head of business development for clearing at Nomura, said: “The costs and resources required for OTC derivatives clearing mean that it is no longer a network-type business where more clients equal more profit. Offering a swap clearing service is a finite resource. Banks and brokers are likely to favour clients that have potential to bring them business in other areas.”

Emir also means brokers and clearing houses need to enable clients to ring-fence the collateral held against swap trades. The type of segregation that clients opt for can also reduce the profitability of the banks’ swap trading businesses.

When trading listed derivatives, brokers collect collateral from clients they serve before delivering this collateral to the clearing house. If two clients have positions that offset each other, the broker will not have to post any collateral to the clearing house and can use it to invest in other areas.

With OTC derivatives, however, deals are more varied so there is much less chance that brokers will be able to enjoy this benefit if clients opt for maximum protection. This will require brokers to ring-fence the collateral they collect from clients, meaning they are unable to reuse it.

Many large fund managers that are in discussions with clearing brokers are expected to favour full segregation of collateral, but there is some worry that brokers may be pricing these services too high.

Xavier Hoche, chief operating officer of trading and securities financing at Axa Investment Managers, said: “While we had initially planned to go for full segregation, we have now decided to choose the omnibus model first. Individual segregation is a brand new concept for many clearing brokers and clearing houses, we cannot really afford it based on the current costs being charged by some firms, and the high operational risk associated with it currently. We will revisit this next year.”

There is also an issue of timing. Infrequent users of derivatives or smaller firms with fewer resources may not yet have thought about the brokers they want to use, which will lead to a last-minute rush as the deadline to clear swaps approaches.

Hoche said: “We started discussions with potential clearing brokers quite early in an effort to avoid any potential bottlenecks, but smaller firms that have less trades to clear and less resources may face difficulties, in particular because clearing brokers may be reluctant to on-board firms with minimal volumes.”

Dixon at BNP Paribas said: “Come the end of the summer, some clients will wake up and realise they only have four to six months before they are obliged to clear and there will be a mad rush as they seek to get up and running. It could take many months just to get the legal documentation completed where a client wants
to heavily negotiate.”

Tight deadlines and a reluctance by banks and brokers to take on new business will have several consequences that might introduce new risks. If smaller clients are frozen out of the market, they could opt to trade exchange-listed derivatives rather than over-the-counter products.

Infrequent users of derivatives may find adequate alternatives like swap futures – newly created listed derivatives that aim to offer a similar exposure to privately traded derivatives – but others may find these products do not meet their needs.

Dixon said: “Some firms, such as those that need to hedge a bond issue, will need to use swaps to obtain the right exposure that matches cashflows. Those firms will either have to bear the additional costs – clearing fees plus costs of margin – or decide to trade different products, which could introduce new basis risk [a risk that a trade and its hedge get out of line so the hedge stops working as it should].”

Contract terms

Clients may also find that they are forced to accept terms and conditions from brokers with little room for manoeuvre. For example, according to McCormack, some firms may have to accept contract terms that allow brokers to collect additional collateral at their discretion and within a short time frame, or termination conditions that allow brokers to cease providing clearing services at short notice.

McCormack at Nomura said: “These can be huge risks for clients. Terminating an agreement with a short notice period, for example, could shut firms out of the market until they can find alternatives.”

Firms such as Nomura and Bank of America Merrill Lynch, which have not traditionally been huge players in the swaps market, are looking to pick up the slack that may result from the capacity shortage.

McCormack said: “There is a good opportunity here for firms like Nomura and we can hope to gain a natural market share of this business. Given the limited resources that some brokers have, clients may need to go to multiple clearing brokers to get the services they need. Those firms that have a credible platform and product offering are likely to get a good market share.”

This article was first published in the print edition of Financial News dated July 14, 2014